Many of you may hear about IRC §121 exclusion which the taxpayer can exclude the gain up to $250,000 or $500,000 for married filing jointly. I also discuss about this provision in the another post. You can read the post How to Minimize Tax on the Sale of Your Primary Residence. One of the most tax traps taxpayer should avoid is that many people purchase the home from ex-spouses during divorce settlement. This tax trap which many people are not ware of, causes the cost basis of the home stay the same though the home price increases. According to the carryover basis rule, any payments made to ex-spouses don’t increase the original joint cost basis of the home. As the result, the cost basis when the couple purchased the property (long time ago) is used against the selling price for tax gain calculation.
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Example: Kevin sold his 50% share of the home to his ex-wife, Nancy for $350,000 as a part of divorce settlement. Nancy and Kevin bought the home 20 years ago for $200,000. Few years later, Nancy had sold the home for $900,000, Nancy would have to pay tax on the entire gain of $700,000 ($900,000 selling price – $200,000 original basis). After $250,000 gain exclusion, she still has to pay tax on $450,000 gain.
Rather than buying the home from her ex-husband, the home should be sold to the third person for $700,000, and with $500,000 gain exclusion neither Kevin nor Nancy pays any taxes. Nancy can use the tax-free gain to purchase a different home for $700,00 as her primary residence. She can sell the home 3 years later for $900,000, and she wouldn’t pay any taxes after $250,000 gain exclusion.
Recommendations
As a part of divorce settlement, neither spouse should purchase the home from the other spouse. To avoid the tax trap, the home should be sold to different persons so that each spouse can take the advantage of $250,000 gain exclusion (assumed that ownership and residence test met).
Khanh Le, preferred name as Jessica Le, is a licensed Certified Public Accountant (CPA). Jessica also earned a Master of Business Administration (MBA) from San Jose State University.
